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Business Processes & Accounting Systems · Week 12

Ratio Analysis — Liquidity, Gearing, Efficiency, Profitability & Shareholder Ratios

Why we use ratios, the five families of ratios with every formula and how to interpret high and low values, benefits and limitations, plus a live ratio calculator built from a mini set of financial statements.

ITE36221 video · 34 min📄 Ratio Analysis - session 12.pdf

1Why ratio analysis?

Ratios are an "analysis microscope" on the financial statements 00:39. They let us:

  • standardise financial information for comparisons
  • evaluate current operations
  • compare performance with the past (trend analysis)
  • compare against other firms or industry standards
  • study the efficiency of operations
  • study the risk of operations
Users Use ratios for
Internal: management, employees 01:38 Strategic planning, goal setting, performance evaluation
External: lenders, investors, analysts Credit decisions, investment decisions, monitoring performance
Family Assesses
Profitability (performance) Profitability levels
Liquidity Short-term solvency: can we pay bills due soon?
Gearing (capital structure) Debt levels, i.e. financial risk
Financial efficiency (activity) How efficiently assets and liabilities are managed
Shareholder (market test) Returns to shareholders

2
  1. Liquidity ratios

Liquidity is the ability to meet short-term obligations, collect receivables and keep a cash position, using cash or near-cash resources 06:30.

Net working capital = current assets − current liabilities. A positive figure suggests adequate liquidity.

Current ratio = Current assets ÷ Current liabilities rule of thumb 2 : 1
Acid-test (quick) ratio = (Current assets − Inventory) ÷ Current liabilities rule of thumb 1 : 1
Value Interpretation
Current ratio 5 : 1 (very high) Strong liquidity, but too much capital may be tied up in idle, unproductive assets 08:35
Current ratio below 1 May struggle to pay short-term debts
Quick ratio 3 : 1 Very strong; can pay without selling inventory 10:08
Quick ratio below 1 Liquidity pressure; depends on selling inventory

Why exclude inventory? It's the least liquid current asset: it must be sold, then collected.

3
  1. Gearing (capital structure) ratios

These compare borrowed funds with owners' equity. They show the financial risk of the business, especially limited companies. High gearing means more dependence on debt and more risk 04:31.

Gearing ratio (lecture notes) = Non-current liabilities ÷ (Total equity + Non-current liabilities) × 100%
Debt-to-equity = Total debt ÷ Total equity
Debt ratio = Total debt ÷ Total assets × 100%
Equity ratio = Total equity ÷ Total assets × 100%
Times interest earned (interest cover) = EBIT ÷ Interest expense
Ratio Interpretation
Debt-to-equity > 1 (e.g. 1.5) Rs 1.50 of debt for every Rs 1 of equity; relies more on debt, higher risk 12:30
Debt-to-equity < 1 Uses more equity than debt; lower risk
Debt ratio 50% Half the assets are financed by debt 13:25
Equity ratio high More stable and solvent
Interest cover 3× Earns 3 times its interest from operating income. Higher means a bigger buffer; low is risky 15:44
Tip

A gearing ratio above about 50% is usually called highly geared.

4
  1. Financial efficiency (activity) ratios

Trade receivables (debtors collection) days = Trade receivables ÷ Sales revenue × 365
Trade payables (creditors payment) days = Trade payables ÷ Cost of sales × 365
Inventory turnover = Cost of sales ÷ Average inventory (days = 365 ÷ turnover)
Debtors turnover = Net credit sales ÷ Average debtors collection period = 365 ÷ turnover
Asset turnover = Sales ÷ (Average) total assets
Ratio Interpretation
Receivables days How long it takes to collect from debtors. Lower is better. A standard of 30 days vs an actual of 60 means a collection problem 18:37
Payables days How long we take to pay suppliers. A standard of 45 days vs an actual of 60 means we're paying late (supplier relations at risk) 20:05
Inventory turnover High means efficient, fast-moving stock. Low means slow-moving stock or overstock, which ties up capital 20:53
Asset turnover High means assets are used effectively to generate sales. Low means under-utilisation 23:04

5
  1. Profitability ratios

Gross profit margin = Gross profit ÷ Sales revenue × 100%
Net profit margin = Net profit ÷ Sales revenue × 100%
Earning power = Operating income (EBIT) ÷ Average total assets
  • GP margin is the gross profit made relative to sales. Higher means better control of production cost (cost of sales) 21:39.
  • NP margin is the profit left after all trading costs and expenses. It shows how well the business controls its expenses and overheads 22:19.
  • Earning power is profit from core operations, independent of interest and tax 23:53.

6
  1. Shareholder (market test) ratios

EPS = Net profit after tax ÷ Number of ordinary shares (must be disclosed in the income statement)
ROE = Net profit after tax ÷ Equity × 100%
DPS = Total dividends ÷ Number of ordinary shares
Dividend payout = DPS ÷ EPS × 100%
P/E ratio = Market price per share ÷ EPS
Ratio High means
EPS More profit per share 26:54
ROE Equity capital is used efficiently to generate profit 25:25
DPS More income to shareholders. Low DPS is typical of growth companies that reinvest 28:17
Payout ratio Distributes most of its earnings, which appeals to income investors but leaves less for reinvestment 29:01
P/E Investors expect high future growth and pay more per rupee of earnings 29:45
🧪 Try it — Ratio calculator — mini financial statements

Edit the figures (Rs '000). Every ratio recalculates with a traffic-light reading.

7Benefits & limitations

Benefits Limitations
Make financial data more meaningful Based on current and past trends, not future trends
Help decide on a firm's creditworthiness Comparisons may be inaccurate: different accounting policies (depreciation, inventory valuation, revenue recognition) or periods
Help predict potential earnings Only as good as the underlying data; window dressing can manipulate results
Show strengths Benchmarks are hard to set 30:29
Spot weaknesses Price level changes: historical cost ignores inflation 31:14
Interpretation is subjective; ratios are interrelated (a gearing change affects profitability and liquidity) 32:00
A strong analysis today doesn't guarantee a strong future
Exam focus

Typical questions:

  1. Calculate a set of ratios from given statements.
  2. Interpret each one: high or low, good or bad, and why.
  3. Compare two years or two companies.
  4. Benefits and limitations of ratio analysis.

Learn the exact formulas from the notes:

  • Gearing = NCL ÷ (equity + NCL)
  • Receivables days use sales; payables days use cost of sales
  • EPS uses profit after tax

8Quick revision sheet

Ratio Formula Good direction
GP margin GP ÷ sales × 100 Higher
NP margin NP ÷ sales × 100 Higher
Current ratio CA ÷ CL About 2 : 1
Quick ratio (CA − inventory) ÷ CL About 1 : 1
Gearing NCL ÷ (equity + NCL) × 100 Lower = less risk
Debt-to-equity Debt ÷ equity Below 1 = less risk
Interest cover EBIT ÷ interest Higher
Receivables days Receivables ÷ sales × 365 Lower
Payables days Payables ÷ cost of sales × 365 Balanced (not too late)
Inventory turnover Cost of sales ÷ average inventory Higher
Asset turnover Sales ÷ total assets Higher
EPS NPAT ÷ number of ordinary shares Higher
ROE NPAT ÷ equity × 100 Higher
P/E Market price ÷ EPS Higher = growth expected
Limitations Past-based · policy differences · window dressing · inflation · benchmarks · subjective

?Self-check quiz

12 questions on this week. Answer them all, then press Check my answers. Your best and latest scores are saved and shown on the subject page.

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